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Saturday, November 2, 2013

"Bubble Truths" and "anxiety about overpriced housing is overblown"

An article from the mainstream media brought interesting insight into a "bubble mind". In an interview, one of the famous Australian economists Stephen Koukoulas (with over more than 25 years of professional experience as an economist in government, as Global Head of economic and market research, a Chief Economist for two major banks and as economic advisor to the Prime Minister) asked simple question:
''What would you prefer? House prices three times' average incomes with 13 per cent interest rates or house prices four or five times' average incomes with interest rates under 7 per cent?
''The bottom line is the repayments are roughly the same.''
Economics used to be a science, not opinion field, so lets see how good scientist one of the Australian most famous economists really is.

According to RBA 1982 was the last year when Standard Variable interest rate was 13% and ratio between an average house price and average income was 3. An average repayment after purchase was 33% of the income (25 year loan, 80% LVR, deposit equal to 60% of annual income). 

Today, ratio between an average house price and average income is around 7 (according to RBA). Standard variable interest rate is 5.95%, repayment 45% of income (30 years loan, 90% LVR, deposit 70% of annual income).

First year repayment today is 36% higher than what it was when home prices were 3 times income and IR 13%.

But that is not the end of the story. Houses take decades to repay, so let see how repayments change over time.

In year 2, repayment was equal to 29% for 1982 buyer (IR dropped to 12.5%, income grew by 9%), and 43.5% for today's buyer (assuming IR and income growth stay the same). 

In year 3, repayment dropped to 25% of income for 1982 buyer (IR dropped to 12%, income grew by 11%) and 41.5% of income for today's buyer (assuming IR and income growth stay the same).

In year 4, repayment dropped to 23% of income for 1982 buyer (IR dropped to 11.5%, income grew by 5%) and 40% of income for today's buyer (assuming IR and income growth stay the same).

In year 5, repayment dropped to 21% of income for 1982 buyer (IR increased to 12%, income grew by 7%) and 38.5% of income for today's buyer (assuming IR and income growth stay the same).

Total cost of house ownership (including deposit) in first 5 years was 190% of income for 1982 buyer and 280% for today's buyer. Despite significantly lower rates, higher LVR and longer loan term, houses today are 47% more expensive in first 5 years than they were in 1982.

Over the life time of a mortgage (25 vs 30 years), today's potential buyer (with assumption that rates stay low) would pay more than twice in income terms for an average house than buyer from 1982.  

Economist Stephen Koukoulas says the anxiety about overpriced housing is overblown because the burden of today's big home loans has been completely offset by the saving from low interest rates.

Completely offset?
Don't worry and buy because "anxiety about overpriced housing is overblown"?!


Monday, February 18, 2013

What caused Housing Bubbles in UK


UK has recorder one of the most volatile house prices in the West since WWII. Many economists use UK as a prime example how "land restrictions cause housing bubbles".  But you they failed to provide evidence that UK home price volatility is caused by land restrictions and not something else. 
They overlooked the fact that beside tough land restrictions UK has the least stable and the most speculative banking system in the West. Maybe that has something to do with price volatility. Lets explore:  

If we look into history of UK banking you will find very interesting correlation between banking regulation changes and housing bubbles. 



Home prices in UK were relatively stable during 50s and 60s. Prices were slowly going up while government was slowly introducing "land development restrictions" in 1960s. This price growth could be attributed to land restriction regulation in addition to other causes (real income growth, etc.).

Suddenly, after decades of stability, house prices spiked in early 70s. Interestingly, that happened immediately after significant bank deregulation process: Competition and Credit Control in 1971 and big bank mergers in late 60s (during just two years in 1968, five big bank mergers occurred) . Competition and Credit Control relaxed bank reserve requirements, allowed deposit banks to participate on the market, removed interest rate collusion ... More interestingly, in 1970 (just before the bubble) new conservative government started relaxing many of the land development restrictions introduced by labour in decade before. Bubble burst and prices drop by 30% by mid late 70s. During this period of falling prices new labour government introduced new and tougher land restrictions but that didn't prevent house prices from falling.

Than, in late 70s, foreign exchange controls were lifted and 1979 Banking Act was passed. That coincided with the housing bubble that peaked in early 80s. This bubble was much smaller but real prices fell almost 20% after the burst. 

New conservative government started reforms that included removal of some land restrictions laws and big banking reform. In mid 80s ‘Big Bang’ reforms were passed (1986). These reforms caused expansion of  building societies and relaxation of lending standards. Deregulation turned building societies into real banks and enabled them to lend money freely. This was followed by big housing bubble of late 80s.   

Finally, world wide deregulation and globalisation of late 90s happened just before great housing bubble of 2000s. Lending standards were dropped, bank funding became obscure and credit issue relaxed. UK banking sector tripled in less than a decade. Speculations became global, included insurances, big funds ...    

This clearly shows that every UK housing bubbles since WWII occurred after a new bank regulation rules were passed (almost identical causation can be showed for USA, Australia ...). In some instances lend restrictions rules had been lifted before bubbles started inflation. These relaxations of land restrictions failed to prevent bubbles from happening.    

In addition, the theory that land supply restrictions cause house price volatility is very hard to apply on UK cities where population significantly declined over the last 40 or 50 years (Manchester, Liverpool, Sheffield ...). These cities did not require much of a new land to meet new demand, still prices were more volatile there than in cities with fast growing population and end even more land restrictions like London.

- Richard Davies, Peter Richardson, Vaiva Katinaite and Mark Manning of the Bank of England - Evolution of the UK banking system - 2010
- Peter Scott - The Property Masters - Taylor & Francis - 2013

Monday, November 19, 2012

Post-construction boom plan?


There is a lot of talk recently about RBA's new great idea of replacing the mining boom with a construction boom. It is quite possible that could work, and we continue growth by shifting ex-mining investments into housing construction. This is not new idea. It was very "successfully" implemented in quite a few places around the world recently. Irish and US governments successfully replaced IT boom of late 90s with period of steady growth driven by construction boom. Chinese government partially did the same thing after their export boom ended. Historically, it seems it's quite easy to succeed with this plan.


BUT, there is one much more important question that nobody seems to be asking  in Australia: even if the great idea of construction boom replacing mining succeeds, what will replace construction boom at its end in three or five years? 





If everything goes as planed, in just 5 years we will have million more homes - half of them empty (around half a million more new homes than new households), we will have around half a trillion more debt (half a trillion less invested in productive business and infrastructure) Maybe we can continue doing the same for 5 more years after. By than we should have million more empty homes and trillion more in debt.

BUT, what will happen after we take more debt and misallocate it into more empty houses? What is the great idea promises us after?

I'm scare even to think about this.
I hope our government's great ideas fails quickly. I hope for that not because I think we will be fine if it fails (we will not), but because I'm sure in 5 years we will be much better than if they succeed. For majority of Australians (especially our kids) going into few years long recession in 2013 is much better option than going into decade long deep depression in 2018.

I hope, we learned something from other's mistakes.

Thursday, June 21, 2012

Census and Australian housing shortage/oversupply

Preliminary Census data is published a few days ago - census link, and as I expected it just confirmed some of my projections.

 First, couple of general (non housing) findings:

  • Total population increased to 21.5m, while total number of dwelling increased to 9.1m.
  • Population growth over the last 5 years was lower than projected (around 300k less – 60k less per year)
  • Household size remained stable at 2.6
  • 65+ is the fastest growing population group
  • Median household income was $64k

Housing data is also interesting.

Ownership rate decreased from 68.1% to 67%. Outright ownership decreased from 34% to 32.1%. Percentage of mortgage owners and renters who spend more than 30% of income on housing increased as well. Income increased only 20% while house prices increased 33.3%, and median mortgage repayment 38% over the previous 5 years. Although income and repayment census data is not very reliable, this suggests that housing became less affordable.

Percentage of unoccupied dwellings increased from 10.4% to 10.7%. Total number of households increased by 616k; number of private dwellings increased by 720k. More than 100k dwellings that were built since 2006 are not occupied. One new dwelling was built for every 2.3 new residents while average household size stayed 2.6.

All this suggests that there is no housing shortage in Australia. In fact, it suggests that oversupply of homes increased in 5 years. The oversupply increase since 2006 seems to be higher than what I predicted here. The likely reasons for this are wrong population growth estimates and my methodology that tends to underestimate oversupply. This means that current oversupply most likely exceeded one million homes.

Oversupply of homes is significantly up, price to income ratio is up, demography is getting worse, …  It seems that there is nothing about real demand and supply that can drive house prices up (or support current prices). It is all down to speculative demand and credit availability. 

Friday, April 13, 2012

Why we are so different - according to RBA

RBA head of financial stability, Luci Ellis, delivered few days ago a speech at Financial Markets Conference in Atlanta. Ms Ellis “explained” why the US housing market bubbled and then busted, and why the Australian housing market will not burst. She made several arguments why we are different. All of them wrong. I will concentrate here on two points:
The first is that housing supply is quite elastic here, at least in enough parts of the country to matter. The housing boom was a construction boom as well as a price boom. As a result, by 2006 there was already a substantial overhang of excess supply (Graph 1).  The inherent stock-flow interaction in the housing market means that construction booms sow the seeds of their own destruction. Prices can undershoot formerly sustainable levels.  
US construction in 2000s was (in nominal terms) lower than in 1970s and 1980s. In relative terms (relative to population or total existing housing stock) construction rate at the peak in mid 2000s was by far lower than in all previous decades.

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This is what she calls US “construction boom”. During the same period we were building at the rate of almost 2%.

More interestingly, in states where developments were restricted construction “boom” was lower while bubble was bigger. Supply side restrictions just amplify house price growth but don’t stop prices from falling. Places with the most supply restrictions (Las Vegas, California …) recorded largest house price drops although none of supply restrictions was lifted in meanwhile. Places with no restrictions like Texas or Georgia recorded no price growth.

This links to the third factor, which is that a range of tax and legal differences, as well as industry convention, created a system that discouraged amortisation. Interest-only loans, explicitly negative amortisation loans and cash-out refinancing, all meant that loan-to-valuation ratios that were high at origination, stayed high well into the life of the loan. American households are less likely to pay their mortgages down ahead of schedule than Australians (Graph 2). Trade-up buyers seem to have high loan-to-valuation ratios in the United States; that doesn't appear to be true in Australia. The result of all this is that the US housing stock is far more leveraged than that in Australia, even during the boom period (Graph 3).

While it's true that Australia does not provide tax benefits for PPOR mortgages it provides significant benefits for property investments. Americans have interest in not paying mortgages ahead of schedule, while Australians don’t. Even with this “advantage” Australians managed to increase LVR during housing boom while Americans decreased it. Australians were adding more debt and much faster (relative to home prices) than they are able to repay ahead of schedule. So, we are paying mortgage faster but or those mortgages grew so quickly that debt is skyrocketing.

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Australia has higher percentage of interest only loans which shows that less people in Australia are interested in owning house – these people only think about price speculation. Since boom started we increased out leverage by almost 50% while Americans decreased their leverage during boom years (by almost 10%). After house price fell US leverage jumped up to level almost 50% higher than pre-boom levels. When our bubble bursts leverage will jump to levels at least 150% higher than  pre-boom period (probably 200% or even more). It’s already 50% up.

RBA is already left with very little credibility and this is just one more step toward losing all of it.

Wednesday, February 8, 2012

Market Inventory vs Bubble Burst

There is strong belief among Australians that housing market will not crash because majority people will not be willing or forced to sell for reduced price. Although it is true that majority of people will not sell at low price, there is misconception how many forced or willing sellers is necessary to crash the market.


Let's see behaviour of market stock in Australia over the past 5 years or so:


Chart1 Stock on the market RPdata
 From the chart, we can see that number of homes for sale doubled since first housing troubles started in 2008. Stock slightly decreased during short boom in late 2009 - early 2010 but increased 50% since then. Similar data comes from SQM - Chart 2
Chart2 - Stock on the market SQM
 From observation of a recent events in USA, I noticed that significant rise in inventories is not needed for price to crash. If we take a look at US existing house inventories (Chart 3) we can clearly see that inventories didn't increased more than inventories in Australia.
Char3 - US existing home inventory

From the chart we can see that home inventories in USA at the peak were lower than current inventory in Australia. At the peak inventories were only about 4% of total housing stock, while that percentage already passes 4.5% in Australia.  It is hard to say that 4% of the total stock is extreme number that caused 33% price crash in USA. We should also notice that stock on the market fell in late 2008 early 2009 when house prices dropped the most. This means there is something else that significantly affects house prices.

Lets take a look at sales:

Chart4 - US home sales
It is clear that drop in sales, significantly affected housing market in USA. Lack of buyers seems to have much larger effect on price than rise in inventories. It is expected there will always be significant number of people forced or willing (for any reason) to sell, but it's hard to expect significant number of buyers (especially if credit freezes and/or unemployment hits).

Let's see whether this holds in Australia

 
Chart 5 - Australia home sales
 It is clear that house price fall in 2008/2009 was caused by significant fall in sales. House prices recovered driven by new buyers although stock on market remained elevated compared to pre 2007 levels.

It looks like inventory levels at the moment are more than enough to enable market crash, it's up to buyers to set market direction. Recent drop in sales (since 2010) is larger than drop recorded in USA during the first two years of price contraction. If soon buyers do not return to the market in large numbers, we may expect price fall to accelerate. There is no need for mass panic sale for prices to fall significantly.

Sunday, December 18, 2011

What drives prices up?

There is common understanding in Australia that FHBs are one of the most important house price drivers. Is this really true?

Let's see what data shows:

Australia Property Investor/FHB market share vs. house prices

It is clear from the chart that there is a weak correlation between FHBs market share and house prices. For most of the time these two series were heading into opposite direction (correlation is slightly negative). On the other hand, property investors (PI) market share is very strongly correlated with house prices. This, of course, does not imply direct causation so we need more information. Just recently, US FED published report* that claims increase in property investors market share was the most important factor that created housing bubble in USA. Lower lending standards attracted large number of highly leveraged investors ready to take big mortgages with expectation of big and quick capital gains. They increased demand and drove prices up. FHBs and upgraders got squeezed and forced to pay ever increasing prices. Increasing prices attracted more investors and feedback started its own life independent of real demand or realistic future prospects. It's almost irrelevant what initiates the feedback loop; once started abundant and easy credit is only thing needed for growth.

According to FED property investor market share in bubble states increased from less than 25% in 2000 to almost 45% in 2006. Similar rise is property investors was recorded in Australia as a whole. In some areas (SE Qld, inner capital cities, ...) significantly higher percentage of investors entered property market and drove house prices by increasing debt to extreme levels. It is hard to imagine this trend to continue for long because of huge debt already accumulated. Once prices stop growing, property investors begin to sell because quick capital gain expectations are gone while big repayment bills continue to arrive every month. Most of highly leveraged and negatively geared investors cannot afford to hold for long without quick capital gain expectations.

Looks like same forces created housing bubbles in USA and Australia. Other minor factors made bubble extents and timings slightly different but core cause for rise and fall seem to be the same.


http://www.ny.frb.org/research/staff_reports/sr514.pdf

Wednesday, November 2, 2011

Australian House Price Trend

There have been discussions that house prices cannot remain flat in “real” CPI adjusted terms because we are earn much more in “real” terms today that few decades ago. I agree that CPI adjusted prices should not be flat because CPI adjustment does not reflect standard of living improvements over time. House prices should follow more realistic measures of our improved wellbeing.

Chart 1 shows house prices in “real” (CPI adjusted) terms as well as growth of our real per capita GDP and per household GDP. These measures are one of few only with long historical series that could be used for price “trend” estimation.


Chart 1 "Real" House Prices vs. "Real" per Capita and Household GDP

Real per capita GDP is good measure because real GDP by itself ignores the fact that more than twice as many people contribute to GDP today compared to 50 years ago. On the other hand, houses are asset needed and owned by households, not the individual persons. In addition, number of homes is closely following number of households. For these reasons, real GDP per households seems to be better measure of the increased ability of households to spend money on home.

From the chart you may see that “real” (CPI adjusted) house prices followed real GDP per household with only few smaller property bubble events in mid 70s and late 80s. Prices returned toward the real GDP per household trend soon after. Since late 90s, house prices significantly deviated from real GDP per household trend. This deviation is strong indication that we are currently experiencing big housing bubble that is not supported by fundamentals.

This chart could give us a feel how much our homes are overvalued - inflated beyond historical and fundamental trend and what level of correction we may expect in near to mid future. Correction may happen with slow deflation in real terms or quick crush. It could be even combination like it was in 1990s when prices fell quickly by 10% in “real” terms and than stagnated while real GDP per household increased.

References:
1. ABS Australian National Accounts
2. ABS Australian Demographic Statistics
3. Stapledon
4. ABS House Price Indexes

Saturday, August 13, 2011

Cost of Mortgage vs. Interest Rates

“New era of low interest rates” is often quoted as one of the main reasons for house price growth during 2000s. The argument claims that low interest rates reduce financing cost allowing house prices to increase for the financing cost reduction. This argument sounds very intuitive and as such it’s not questioned by many. So, let’s see how interest rates affect real (CPI adjusted) cost of house purchase.

First of all we should check relation between CPI and mortgage interest rates. This relation will significantly affect real cost of mortgage. On Chart 1, we may see strong correlation between the two but we should also notice that ratio between mortgage interest rate and CPI is decreasing as CPI is getting higher. In other words the lower the CPI - banks are charging higher margin. This means that the lower CPI, the more (in real terms) mortgage holder pays to bank over the life time of the mortgage.

Chart 1 - CPI and Standard Variable Bank Mortgage Rate
To calculate cost of mortgage financing we developed Mortgage Interest Rate to CPI ratio - see Chart 2.

Chart 2 - Annual CPI and Standard Variable Mortgage Interest Rate to CPI Ratio 
From the chart we may clearly see that the lower CPI the higher ratio. During the low interest ratio periods mortgage is much more expensive relative to cost of funding. This relation can be expressed in form of chart  based on historic data - see chart 3.
Chart 3 - Standard Variable Mortgage Rate to CPI ratio vs. CPI

When CPI is low banks are charging relatively (to CPI) high interest rates; on the other hand when CPI is extremely high banks charge less that CPI (they lose money). This combined with the fact that high inflation quickly reduces principal, should make us think that in real terms high CPI and higher mortgage rates could be better deal for mortgage holders. Chart 4 shows total cost of mortgage in CPI adjusted terms for 30 years 90% LVR loan for a given CPI and calculated interest rate based oh historic relation. Cost is calculated by assuming that CPI and interest rates remain the same over the entire period of the mortgage. This assumption is used to simulate cost dependency on low vs. high interest rate "eras" - argument used by people who claim that low Interest Rates (CPI) makes house purchase financing cheaper and house prices higher.

Chart 4 - Total Real Mortgage Cost Index (30 year)
Chart 4 shows that real cost of mortgage is significantly lower during periods of very high interest rates (high CPI). The reason for this is the fact that loan principal gets quickly eaten by inflation, and mortgage repayments quickly drop relative to income and other costs. It is also clear from the chart that cost of mortgage is relatively constant for periods when CPI is between 2 and 9%. So there are no reductions in total cost of financing house purchase between periods with moderate inflation (CPI 7-8%) e.g. during 1980s and periods with lower inflation (CPI ~3%) e.g. during 2000s.

Many people sell home before the end of the mortgage term so let's check what is the cost of mortgage for the first 10 years of 30 year mortgage - Chart 5. This period is selected because most of PPOR properties are held for at least 10 years before sale.

Chart 5 - Real Mortgage Cost After the First 10 years

As expected, cost of financing during first 10 years is higher for high interest rate mortgages, but unexpectedly for very high CPI periods cost decreases significantly. Cost of financing for the first 10 years is the highest for CPI around 8%. The difference between maximum cost for CPI of 7-8% (during 1980s) and cost for CPI of 3% (during 2000s) is around 20%. So if majority of people hold PPOR property for 10 years, cost of financing reduction due to low rates could drive prices 20% in real terms between 1980s to 2000s. 

Lower interest rates also make repayments during first few years lower compared to income. This means that people can take much higher debt during low inflation periods if repayment as percentage of vs. income lending criteria remains the same.  

Chart 6 - Real Mortgage Cost Index
From Chart 6. we may see that remaining part of a mortgage after 10 years is significantly lower during periods of higher inflation. This means that people much quickly repay their debts than what is the case for low inflation periods.

We may conclude that total cost of financing has general trend of falling with CPI and interest rate increase and it is fairly constant for low (3%) and medium (7%) CPI periods. As such, it cannot be used to justify real house price increase. Short term (10 year) mortgage cost is slightly lower during low inflation periods and could be used to justify house price increase of around 20%.
Most importantly lower interest rates make initial repayments lower allowing people to take much larger debt relative to income and that could be one of the key drivers (combined with lower LVRs) for house price increase during 2000s.  

Low rates (CPI) allow people to take much more debt relative to income, they make mortgages more expensive over the mortgage life and they keep people in high debt for much longer period by keeping loan principal high. This is not only the key reasons why our (spending) economy is suffering but also the reason why it will not be able to recover anytime soon (if CPI remains on these levels). 

To avoid this debt trap caused by low CPI and mortgage rates, banks could adjust lending criteria and take into account CPI levels. They had to reduce maximum LVR and maximum repayment relative to income to offset low interest rate trap. During 2000s, not only that we let low rates to do  the damage but also our banks increased LVR and maximum repayments relative to income, creating huge debt problem that will cause economic pain for extended period.

Friday, July 29, 2011

"Predictions" by Google Insight

There are a lot of discussions about timing of Australian property bubble. It is impossible to predict timing of events such is bubble burst but to make this interesting I checked Google Insights for Search to see whether search for “property/housing bubble” can be used for predictions.
Findings are quite surprising – see charts.

Charts 1 House prices and Google Searches - Ireland

Charts 2 House prices and Google Searches - Spain

Charts 3 House prices and Google Searches - UK

Charts 4 House prices and Google Searches - USA


From charts you may notice that peak search for phrases “property/housing bubble” happened 2-3 quarters before bubbles bursted in these countries. This is very interesting and IMHO probably tells a lot about the fact that sentiment plays very important role in market movements. What is surprising to me is the fact that search for bubble information drops before bubble bursts and stays lower when most equity wealth disappears and most of people lose their homes.    

Now, lets take a look at Australian search for "housing bubble"

Charts 5 Google Search "housing bubble" - Australia
Search for "housing bubble" peaked in November 2010 - 8 months ago. Based on Google Insight for Search information for other countries with similar housing bubbles, Australian housing market is just at the turning point and future doesn't look good. Data that is being published these days suggests that Google might be right.

BTW. UK market also doesn't look promising after slight recovery in 2008, "search sentiment" is up again.